Fiscal Policy Chris Edmond NYU Stern Spring 2007 1 Agenda • Fiscal policy indicators – revenue: taxes, issuing debt – expenditure: purchases, transfers and interest payments • Fiscal policy principles – government’s ‘intertemporal’ budget constraint – deficits and debt sustainability – principles of taxation, debt management 2 Fiscal policy concepts • Fiscal policy – government decisions to spend, raise revenue, and issue debt • Expenditure – purchases of goods and services (consumption + investment) (schools, police, courts, military, roads) – transfers to households and firms (social security outlays, health care) – interest payments to holders of government debt • Revenue – personal and corporate income taxes, tariffs, etc – social security contributions 3 Government budget constraint • Period-by-period expenditure = income • In particular G t + V t + rB t = T t +(B t+1 - B t ) where G t = government purchases of goods and services V t = transfer payments from government to households T t = tax revenue B t = government debt (‘bonds’) 4
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Fis cal P olicy - NYU Stern School of Businesspages.stern.nyu.edu/~cedmond/ge07pt/LSession10_4slides.pdf · Fis cal P olicy Chris Edmo nd NYU Stern Spring 200 7 1 Ag enda ¥ Fi scal
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– big spenders? big taxers?– borrowing a lot?– very indebted?
• Fiscal policy indicators
– spending, revenue, deficit, debt (all scaled by GDP)
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Fiscal indicators (all as percentage of GDP)
Country Spending Revenue Deficit Debt
Canada 39.4 40.6 +1.1 70.6
Czech 46.1 41.7 -4.3 39.1
France 54.5 50.7 -3.7 74.0
Germany 47.8 43.9 -3.9 67.0
Japan 36.7 30.2 -6.5 163.5
Korea 27.9 31.3 +3.4 19.3
Sweden 57.5 58.0 +0.5 61.2
UK 44.4 41.2 -3.2 43.4
US 35.6 31.2 -4.4 63,5
OECD 40.6 37.1 -3.5 76.8
Source: OECD Economic Outlook, 2005
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What have we learned so far?
• Fiscal policy
– decisions to spend, raise revenue, issue debt
• Deficit
– government expenditures less revenues– change in government debt– ‘primary’ deficit + interest payments
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Fiscal policy principles
• Intertemporal budget constraint
– implications of rolling over the period-by-period constraint
• Deficits and debt sustainability
– how much government debt is sustainable?
• Principles of taxation and debt management
– how do taxes a!ect incentives to work and save?– who/what should be taxed? how high should taxes be?– should taxes respond to war? business cycle? demographics?
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Can governments keep running up debt?
• Government budget constraint
Gt + Vt + rBt = Tt + (Bt+1 !Bt)
• Government borrowing today implies interest cost tomorrow
• To get complete complete picture, ‘rollover’ these period-by-period budget constraints
• Result is the government’s intertemporal budget constraint
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Digression on present values
• If interest rate is r > 0, present value of a dollar in t periods!
11 + r
"t
• Present value of a flow that pays Xt at t is
!#
t=0
!1
1 + r
"t
Xt
• Simple example: if Xt = X all t, then
!#
t=0
!1
1 + r
"t
X =1 + r
rX
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Debt dynamics
• Define primary government surplus
Xt " Tt !Gt ! Vt
• Then government budget constraint is
Bt+1 !Bt = rBt !Xt
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Debt dynamics
• Define primary government surplus
Xt " Tt !Gt ! Vt
• Then government budget constraint is
Bt+1 !Bt = rBt !Xt
• Rearrange to get
Bt =1
1 + r(Bt+1 + Xt)
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Debt dynamics
• Define primary government surplus
Xt " Tt !Gt ! Vt
• Then government budget constraint is
Bt+1 !Bt = rBt !Xt
• Rearrange to get
Bt =1
1 + r(Bt+1 + Xt)
• And next period
Bt+1 =1
1 + r(Bt+2 + Xt+1)
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Iterating forward
• This period
Bt =1
1 + r(Bt+1 + Xt)
• And next period
Bt+1 =1
1 + r(Bt+2 + Xt+1)
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Iterating forward
• This period
Bt =1
1 + r(Bt+1 + Xt)
• And next period, etc,
Bt+1 =1
1 + r(Bt+2 + Xt+1)
• Iterate forward
Bt =1
1 + r
!1
1 + r(Bt+2 + Xt+1) + Xt
"
• Keep doing this many times
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Intertemporal budget constraint
• After some S + 1 iterations, we get
Bt =!
11 + r
"S+1
Bt+S+1 +1
1 + r
S#
s=0
!1
1 + r
"s
Xt+s
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Intertemporal budget constraint
• After some S + 1 iterations, we get
Bt =!
11 + r
"S+1
Bt+S+1 +1
1 + r
S#
s=0
!1
1 + r
"s
Xt+s
• As S #$, we get . . .
Bt =1
1 + r
!#
s=0
!1
1 + r
"s
Xt+s
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Discussion
• Intertemporal budget constraint
Bt =1
1 + r
!#
s=0
!1
1 + r
"s
Xt+s
• Implications
– debt is present value of future primary surpluses– debt is current promise to make future payments– current deficit must be o!set by future surpluses– so a deficit-financed tax cut now means . . . ?
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Problems
• Intertemporal budget constraint
Bt =1
1 + r
!#
s=0
!1
1 + r
"s
Xt+s
• Implications:
– can we always rollover period-by-period budgets?– what if government promise to repay is not credible?– other problems?
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Debt sustainability
• Simple model
– government budget constraint
Bt+1 !Bt = rBt + Gt + Vt ! Tt
– real output grows at rate g
Yt+1 = (1 + g)Yt
– primary deficit/surplus is given exogenously
bt " Bt
Yt
xt " Gt + Vt ! Tt
Yt
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Debt sustainability
• Debt/output dynamics
bt+1 ! bt =r ! g
1 + gbt !
11 + g
xt
(see notes for details)
• Simple example, xt = x all t
bt+1 ! bt =r ! g
1 + gbt !
11 + g
x
• Steady state debt/output ratio
b =1
r ! gx
(‘sustainable’)
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Example
• Steady-state debt/output ratio
b =1
r ! gx
• Example: US debt/output ratio is 0.60. If g = 0.02 and r = 0.05, what surplus isneeded to sustain this indefinitely? Answer:
x = (r ! g)b= (0.05! 0.02)0.60= 0.018
A primary surplus of 1.8% of GDP.
• Question: what if g > r?
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Taxation
• Tax instruments
– labor income taxes– capital income taxes– consumption taxes, sales taxes, value-added taxes– others?
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Incentive e!ects
• Most taxes a!ect incentives
– taxes on labor income a!ect decisions to work– taxes on capital income a!ect decisions to save/invest– distort allocations of scare resources, ine"cient
• ‘Lump-sum’ or ‘poll’ taxes do not a!ect incentives
– how much does that matter?– e"ciency vs. equity?
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London, May 1990
poll tax protests/riotsTrafalgar Square
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Principles of taxation
• What causes the least ine"ciency?
– tax things with relatively ‘inelastic’ demand or supply(cigarettes, alcohol, etc)
– use large base to keep tax rates low(minimize deductions, exceptions)
• Should we tax capital?
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Principles of taxation
• What causes the least ine"ciency?
– tax things with relatively ‘inelastic’ demand or supply(cigarettes, alcohol, etc)
– use large base to keep tax rates low(minimize deductions, exceptions)
• Should we tax capital?
– as little as possible: very elastic supply in long run– problem: very inelastic supply in short run, so governments are tempted
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Sources of tax revenue, share of total
Country Personal Corporate Social sec. Property Sales/VAT
Canada 35.0 10.1 17.2 9.8 26.3
Czech 12.8 11.8 44.1 1.5 29.7
France 17.3 6.6 39.5 7.5 25.4
Germany 25.1 2.9 40.3 2.3 29.2
Japan 18.4 12.2 38.3 10.8 20.1
Korea 12.8 12.8 19.1 12.7 38.8
Sweden 30.4 4.8 34.4 3.2 26.4
UK 29.8 8.1 17.0 12.0 32.7
US 37.7 6.7 26.1 11.9 17.6
OECD 25.7 9.4 26.3 5.5 31.9
Source: OECD Economic Outlook, 2005
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War finance
• How should wars be financed?
– raise taxes?– issue debt?
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War finance
• How should wars be financed?
– raise taxes?– issue debt?
• Should run deficit during war, issue debt
– tax smoothing– repay debt by running surpluses in peacetime
• Problems?
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Business cycles
• How should fiscal policy react to business cycle?
– cut taxes in recession?– raise taxes in boom?
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Business cycles
• How should fiscal policy react to business cycle?
– cut taxes in recession?– raise taxes in boom?
• Fiscal policy is too clumsy for ‘active’ management
– takes time to pass legislation– instead rely on ‘automatic stabilizers’ and monetary policy
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Demographics
• What are the fiscal implications of demographic changes?
• How should government respond to aging population?
• Issues
– increasing dependency ratio (more retirees per working person)– unfunded liabilities (social security, medicare obligations)– what are our intergenerational obligations?
• What are the right policy responses?
– tax increases?– benefit cuts?– more debt?– immigration?
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Talking points
• The longer the deficit continues, the larger the tax burden on future taxpayers.
• Do you agree?
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Talking points
• The longer the deficit continues, the larger the tax burden on future taxpayers.
• Do you agree?
– yes, if you mean Tt, not necessarily if you mean Tt/Yt
– if you mean the latter, answer depends on r vs. g
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Talking points
• Social security
– a social insurance program (e.g., disability)– not a retirement account– if so, should we compare ‘returns’ on social security with returns on other
investments?
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What have we learned today?
• Government deficit
– change in government debt, ‘primary’ deficit + interest
• Intertemporal budget constraint
– debt is present value of future primary surpluses– implications for debt sustainability
• Principles of taxation
– tax inelastic goods and services to minimize e"ciency losses– use large base to keep tax rates low– tax smoothing: run deficits in wartime, don’t use fiscal policy to actively manage